Strictly Business

One situation I often encounter with small businesses is that sometimes they don’t always document the transactions they enter into with their owners and other related parties.  For instance, let’s say that two owners of a corporation decide that their corporation needs more funding.  However, they don’t want to invest more equity into the business.  They are willing to extend a loan to their company and expect to get paid back over the next few years with interest.  Here’s how that should work (assuming this company is a C Corporation):

The corporation would make payments of principal and interest back to the shareholders.  The corporation would be able to deduct the interest as an expense.  The owners would not need to pay taxes on the principal but would pay taxes on the interest.  There are no double taxation issues because the interest expense is deducible to the corporation.

Unfortunately, small business owners often don’t take the time to properly document transactions like this.  They may enter it into their accounting books, but the don’t prepare any loan documents, nor do they prepare any board resolution authorizing the company to enter into the loan.  After all, from the owners’ perspective, this is a loan to “themselves” and it seems like a waste of time and money to have official documents prepared.  This can cause a couple of problems down the road.

First, if the IRS audits the company, they will ask to see the loan documents and resolutions authorizing the transaction.  When the owners can’t produce them, the IRS can (and often does) recharacterize the transaction as a dividend.  As a consequence, the loan interest is no longer deductible.  Therefore the owners will pay double taxation on the interest.  In addition, depending on the capital structure, the principal payments could also be deemed a taxable distribution, thus causing the owners to pay income taxes on the return of principal (which never would have happened had the transaction been properly documented as a loan).

Another area where this can cause problems is when the owners decide to sell their business or sell an interest in it to outsiders.  Failing to properly document earlier transactions can cause problems in due diligence, which any sophisticated purchaser or investor would perform on a business he intends to acquire.  The process of cleaning the mess up could be expensive (far more expensive than simply having documents prepared from the outset.)

A loan is just one example of the type of transaction that should be documented even when made between related parties.  Another example is leases.  Many business owners lease their own property to their business.  But if they don’t prepare a written lease, the rent payments could be recharacterized as dividends or distributions.  Here’s a couple of other examples:  employment agreements, service agreements, purchases and sales of assets, and sale-leaseback transactions. All of these transactions between a business and its owners should have some level of legal documentation.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Business owners will often say that they hired someone as a “1099 employee.”   What they actually mean is that the business came to an arrangement with a worker that deems him to be an independent contractor, and as a result, it doesn’t have to follow any of the laws involved in hiring an employee.  This includes not having to withhold any amounts for taxes, not having to pay the employer’s portion of social security and Medicare taxes, and not having to pay any premiums for workers compensation or unemployment insurance.  It becomes the worker’s responsibility to pay the employer’s portion of social security and Medicare taxes through the self employment tax. The worker must also perform their own withholding through quarterly payments to the IRS.  From the employer’s perspective, this seems to be a great arrangement.  They avoid administrative and tax expenses.  The only problem is that it is often illegal.

There is no such thing as a “1099 employee.”  The “1099″ part of the name refers to the fact that independent contractors receive a form 1099 at the end of the year, which reports to the IRS how much money was paid to the contractor. In contrast, employees receive a W-2. Service providers are either employees or independent contractors; they cannot be both.  Often a company may choose to designate certain service providers to be independent contractors instead of employees, but this is not always up to the parties to decide.  In many situations, workers who are deemed to be independent contractors by agreement between the company and the worker are still considered to be employees by law.  When that happens, the IRS, the department of labor, and state agencies, will reclassify the worker to be an employee and treat the employer as if it simply violated its legal obligations in how it handled that employee.  As a result, the consequences for misclassifying a worker can be quite severe.

How do you correctly decide whether a worker can be considered an independent contractor and when they must be considered an employee?  The IRS has published guidelines on making this determination based on three sets of factors: behavioral control factors, financial control factors, and relationship control factors. [1]  Examples of each are:

Behavioral Control Factors

• Does the worker decide their own schedule and location of work?
• Is the company providing training to the worker?
• Does the worker have their own employees?
• Does the worker decide the order and sequence of services?
• Does the worker decide what kind of reporting is provided to the company?

Financial Control Factors

• Will the worker submit invoices?
• Will the worker pay their own business and travel expenses?
• Does the worker furnish his own tools and materials
• Does the worker have his own business?
• Does the worker advertise their services?
• Will the worker recognize profit or loss based on good or bad decisions?

Relationship Factors

• Is the worker is retained for a specific project or are they involved in ongoing operations?
• Does the worker have other clients?
• Will the worker maintain independent activities?
• Does the worker maintain his own insurance?
• Is there a signed contract between the worker and the company specifying that they have an independent contractor relationship?
• Does the worker receive benefits?
• Is the relationship temporary or open-ended?
• Are the services provided a key aspect of the regular business of the company?

The final determination is made by weighing whether the factors favor classifying the worker as an independent contractor or as an employee.  If the weight of the factors indicate that the worker should be classified as an employee, then the worker must be so classified, regardless of any agreement between the employer and the worker.  Misclassifying a person who should be an employee as an independent contractor can have significant consequences.  The IRS can and often does take action against employers who misclassify employees, including requiring the employer to pay all taxes that should have been withheld plus an additional penalty.  In addition, the state government may seek worker’s compensation insurance and unemployment insurance premiums that should have been paid.  Finally, the worker himself may file suit, seeking back pay for overtime, payroll tax contributions, and employee benefits.

Misclassifying employees as independent contractors can be an expensive mistake for a business.  Therefore, you should consult an attorney or accountant to ensure that your employment relationships are in compliance with the law.

Footnotes

[1] The IRS previously used a 20-factor test to make this determination.  This 20-factor test has since been replaced with the one described in this post.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.